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Keeping the lights on

With concerns intensifying over the UK's narrowing energy 'supply margin', we examine whether prospects for listed power suppliers and infrastructure groups are being hamstrung by regulatory constraints
September 11, 2015 and Mark Robinson

In the summer of 2003, less than two years after the World Trade Center attacks and with anxieties over another terrorist atrocity at fever pitch, the biggest power outage in North America brought huge swaths of the north-east, the midwest and Canada to a standstill. Around 57m people were left without mains electricity, while great cities such as New York and Toronto were plunged into darkness; great news for candle makers, but less so for most other areas of the economy.

In the weeks that followed, investigators raced to identify the source of the outage, while speculation mounted over the possibility of a state-sponsored cyber attack. Ultimately, however, Occam's razor prevailed; the cause of the outage was eventually traced back to overloaded transmission lines in Ohio, which - due to garden variety procedural failures - eventually sparked a cascade of shutdowns in electrical grids across New York, Ontario, New Jersey and beyond. North America's grid systems are finely balanced and tightly interwoven, so a seemingly innocuous operational error can have a domino effect if left unchecked.

 

The narrowing 'supply margin'

You might have thought that the experience across the Atlantic would have concentrated minds in Westminster, but you would be disappointed. Unfortunately, the subsequent response by successive administrations makes you wonder if UK politicians are capable of implementing a co-ordinated response to long-term planning challenges. Public necessity ground up against political expediency, while utilitarianism gave way to the focus group.

We seem to take access to an uninterrupted flow of electricity as an inalienable right. But many people recall the miners' strikes of the early 1970s, which eventually led to widespread blackouts and the introduction of a three-day working week. Trade unionists can no longer readily turn off the lights in the UK - this side of Jeremy Corbyn, at any rate. But the UK government and industry regulator Ofgem are now being pulled in different directions by issues linked to infrastructure spending, energy security, statutory requirements, climate change agreements, nuclear policy and perhaps, above all, by consumer dissatisfaction at rising energy bills.

Substantive changes in the way that we generate, store and transmit energy will take 20 years or more to implement. And although the amount of energy we can generate or access (including from other countries' energy grids) is still in excess of our peak usage, our failure to implement meaningful reforms rapidly enough is likely to see that gap - otherwise known as the UK's 'supply margin' - narrow appreciably in the near term, particularly as coal-generated capacity is retired. Although the UK is moving towards more renewable power in response to climate change treaty, opinions are still divided on how to do it: should nuclear be part of the mix? Which energy sources should receive government subsidies, and how much?

The end result - at least for the publicly listed groups serving the UK's energy and infrastructure needs - is that opportunity is increasingly tempered by intervention and distorted pricing models. It's far from an ideal operating environment, but we've taken a look at some of the key issues facing the power providers - and whether they will transmit into peak profits.

 

Renewable subsidies face a squeeze

Although the economics are constantly changing due to technological advances, it remains the case that the widespread adoption of renewable power sources is bound up with the level of subsidies on offer. And that's the main problem: economies like the UK, which are committed to reducing CO2 emissions through international treaties and protocols, are unlikely to fulfil their obligations in the absence of substantive support from central government. And, if anything, government support in the UK (the SNP excepted) and, indeed, across Europe as a whole, seems to be waning.

Even Germany, which has been held up as something of an exemplar by proponents of renewable energy, could struggle to meet its initial target of generating 40 per cent of its electricity from renewable sources by 2025. Indeed, the country had hoped to generate the lion's share of its power from renewable sources by the middle of the century. Germany's ambition to become a reduced- or even post-carbon economy is now at risk from cuts to solar subsidies and watered-down EU green energy targets. Policymakers in Berlin have come under increased pressure from industrialists, who believe that a wholesale switch to sun, wind and other renewable sources would invariably result in intermittent power supply, thereby imperilling Germany's peerless manufacturing base.

A power survey conducted by the European Union (EU) across its 28 member states underlines why the switch to renewable forms of power generation would slow dramatically without intervention in energy markets. Improvements in photovoltaic cell technology mean that solar power on the continent can now be generated for €100-€115 per megawatt hour, which is about the same rate as nuclear and natural gas. However, coal-fired electricity is still about 30 per cent cheaper. Short of effective regulation, the disparity provides a strong disincentive for increasingly cash-strapped member states to prioritise change.

In 2012, the EU spent around €130bn on power sector support. The largest proportion - 30 per cent - was allocated to renewable energy schemes, reflecting efforts to expand the share of renewable sources in the overall energy mix. However, the EU doesn't just spend your money in a bid to ward off climate change; Brussels also provides billions in subsidies for Europe's remaining coal-mining regions.

 

Household bills and the DECC

While supporters of green subsidies on the continent are facing increased opposition, the situation at home is even more fractious, with the Conservative-majority government intent on scaling back support for renewable energy programmes. It's now estimated that renewable energy schemes will require around £9bn a year in subsidies by 2020. Naturally, UK households will be expected to pick up the tab, but the political fallout on this issue could derail the UK's efforts to achieve a renewable target rate of 15 per cent of generating capacity by 2020.

Tory ministers blame the problems on mismanagement by the Liberal Democrats who previously held the reins at the Department for Energy and Climate Change (DECC). A Whitehall leak revealed that the DECC has already overspent its five-year budget to support renewable energy projects by around £1.5bn - and the Treasury is certainly in no mood to support departmental profligacy.

George Osborne has already taken the decision to scrap the climate change levy, and the DECC has launched a consultation on reforming subsidies for solar projects of 5 megawatts (MW) or less under the Renewables Obligation (RO) - a government policy that compels suppliers to source a portion of the energy they provide to customers from renewable sources.

With an increasingly hard-nosed approach to Whitehall budgets and even more pressure on UK power companies to trim their bills in the wake of separate findings by the Competition and Markets Authority (CMA), there is reduced appetite to subsidise green energy. Recently, the centre-right think-tank Policy Exchange claimed that the average household energy bill had risen by £120 over the past five years due to what it called "ill-thought through energy and climate policies".

The statement falls into line with projections from the Office for Budget Responsibility (OBR) that subsidies for renewable energy will exceed the levels expected when the spending cap, known as the Levy Control Framework (LCF), was established. Statements like this - and widespread disaffection among households at the rising cost of energy - provide the backdrop to recent measures by the DECC to reduce subsidies to renewable energy in what it says is an effort to keep down household bills. And with several fixed-rate energy tariffs - including popular deals from British Gas and EDF - about to expire, many UK households are facing a shock rise in their energy bills in September, when they're automatically switched to their supplier's standard-rate tariff - so we're unlikely to witness a surge in popular support for subsidies as winter approaches.

 

Drax suffers despite biomass switch

Bearing in mind the regulatory changes we've witnessed, it should come as no surprise that shares in biomass energy generator Drax Group (DRX) and wind power producer Infinis Energy (INFI) have been clobbered over the past 12 months. Drax's share price has fallen by more than half in that time, primarily as a result of adverse regulatory announcements rather than a negative earnings performance. Management has estimated its cash profits will be down by £30m this year and £60m in 2016 as a result of the loss of an exemption under the climate change levy (CCL). Drax - the UK's largest generator of renewable power - has so far converted three of its six coal-fired plants into wood-pellet-burning units. Two of these units receive support under the RO scheme, something that will continue, as the subsidy removal is not retrospective. However, a third unit is still awaiting EC state aid approval to determine whether it is eligible to receive funding under the new contracts for difference (CFD) regime.

 

Drax has been hit hard over the past 12 months

 

Drax differs to other types of renewable generators as its biomass-burn units deliver the security of supply on demand that wind turbines and solar panels are not able to - an important plus point. The group has done well as a result of its increased biomass generation. Indeed, this was the driving force behind better-than-expected trading figures during the first half of this year. Biomass accounted for 37 per cent of net power sales, compared with 23 per cent at the same time in 2014. As the volume of biomass grew by almost three-quarters, Drax received more funding under the RO regime.

While this announcement caused a brief rally in the shares, they have since fallen back once again. Angelos Anastasiou, utilities analyst at broker Whitman Howard, says he does not see a particularly good reason for the fallback. Mr Anastasiou says: "We still believe that there is considerable upside over the longer term, and a near-term trigger could be positive news on progress with the EU state aid process for Drax's third unit conversion, including any update on RWE's (RWE) Lynemouth plant, which is also seeking EU state aid clearance, but from a more advanced position. Hence, we see the recent share price retrenchment as an opportunity."

Prior to these regulatory hits, Drax had been pondering a fourth biomass conversion. "We would, of course, like to do more biomass conversions, but whether or not we can will depend on whether budget is available to do that through the CFD process," says Michael Stott, interim finance director at the group. On the other hand, Drax's coal-fired plants are being hit by carbon tax costs. Mr Stott says the carbon tax levies £18 per tonne of C02. "The margins available to coal-fired are relatively lower but the carbon tax is frozen after 2020," says Mr Stott. "Ultimately what the future for coal-fired generation will be, will depend on what happens to the prices of carbon beyond 2020." Investing in Drax has undoubtedly become more risky. Mr Stott says the group should benefit from having three biomass units up and running in 2016 as well as having a full year of its Baton Rouge pellet production facility operational in the US. While RO funding for its two converted units is safe, questions remain over how Drax will propel its earnings over the medium to longer term.

 

Infinis blown off course by wind policy?

Infinis's trading performance over the past year tells a similar story. Its shares have fallen by more than a third during that time, driven down by the closure of the RO scheme to new onshore wind projects from April 2016 - a year earlier than expected. The group is guiding towards a £7.5m reduction in cash profits in 2016 and £10-£11m in 2017. Fellow wind onshore power generator Renewable Energy Generation (WIND) also faces uncertainty over some of its plans. It currently operates 11 wind projects across the UK, with a total capacity of 34.7MW, and has an additional 38MW of projects that meet the DECC's grace period conditions. Chief executive Andrew Whalley says the company has another two projects that are yet to receive confirmation and that the group is awaiting further clarity on grace periods.

The government argument for this measure is one of affordability. However, the DECC is consulting on a grace period for projects that, as of 18 June, had planning consent, a grid connection offer and acceptance of land rights for the site upon which they plan to build. New onshore wind projects will now need to bid under the CFD regime, rather than being automatically eligible for funding under the RO scheme. Under CFD, low-carbon generators are paid the difference between the estimated market price for electricity, known as the 'reference price', and the estimated cost of developing the technology or the 'strike price'. It is unlikely that projects will be taken up if they involve a larger level of funding.

 

Infinis's shares have fallen by more than a third

 

In its first-quarter trading update management said it was "highly confident" that its 'A' Chruach, Galawhistle, Sisters and North Steads projects meet the grace period criteria and therefore qualify as RO projects. Management is still discussing how the changes will impact future strategy and plan to update the market when the group delivers its half-year results. However, it is important to note that if these sites are eligible under the RO scheme, then funding for its 135MW growth target will be secure. It is also important to remember that Infinis is not solely reliant on wind generation, but also produces energy via landfill gas (LFG). In fact, LFG is currently responsible for the lion's share of group production and gross profit, outstripping management's expectations of output and generating £113.5m in gross profit last year.

Infinis is an income stock and while the regulatory backdrop is shaky, investors are rewarded with a bumper dividend. In 2015 the group yielded 10 per cent. For now the group's dividend policy remains intact - to grow at least in line with inflation. However this is likely to come under pressure as a result of the CCL exemption removal. Analysts at Investec Securities have rebased the dividend to 10p for full-year 2016, compared with 18.3p in 2015. This still gives a decent estimated dividend yield of 6.5 per cent, increasing by inflation thereafter. That said, forecast dividend cover is precariously low, covered just 1.1 times in 2016 and one times in 2017

 

% price chg (6-mth)

% price chg (3-yr)

P/E

Div. yield (%)

EPS growth (%) 2015/16

FCF yield (%)

ROC (%)

Last IC View:

Market-cap (£bn)

Amec Foster Wheeler

-14.3-339.55.82.24.316.9Buy, 762p, 27 Aug2.94

Atkins (WS)

5.611814.62.53.45.918.9Buy, 1,503p, 12 June 20151.46

Babcock International

-5.820.413.92.512.45.67.8Buy, 1,100p, 21 May 20154.81

Balfour Beatty

8.5-8.8na2.1negneg-10.9Hold, 244p, 12 Aug 20151.82

Centrica

2-21.112.24.7-7.1139.2Hold, 270p, 5 Aug, 201512.99

Drax Group

-29.2-3911.54.3-30.10.35.4Sell, 283p, 28 July 20151.17

Infinis Energy

-33na1115.3-11.69.57.5Buy, 184p, 29 May 20150.4

National Grid

-522.514.751.25.26Buy, 901p, 26 May 201532

SSE

-2.411.4125.9-8.44.67.8Hold, 1,524p, 24 July 201514.8

Weir Group

-30.7-25.511.23.36.514.38.6Hold, 1,542p, 2 Aug 20152.83

Source: Reuters, Bloomberg, Capital IQ

 

  

The gas storage shortfall 

The UK is reliant on an ageing stock of nuclear and coal-fired power stations, many of which are due for decommissioning. If these plants are not replaced by new-build (less likely as a consequence of last year's capacity auction) then it is probable that much of the new capacity will be provided by conversion of existing plants to gas-firing technologies, thereby increasing demand. In the event of supply disruption, the lack of storage capacity and increased demand leaves the UK vulnerable to power outages.

Although several underground storage facilities are in various stages of planning or construction, these will not be available for a number of years, during which time imports will rise. Another consequence of our relatively low gas storage capacity is that it is more difficult for the UK to benefit from excess capacity - and lower prices - in gas wholesale markets. It's part of the reason why our energy bills don't seem to readily reflect any fall-away in hub prices. The UK's gas-fired power plants began to feel the squeeze of low profit margins in the early part of this year, which probably helps to explain why the majority Conservative administration has decided to trim green subsidies.

All of this matters because the proportion of electricity generated in the UK through natural gas is set to increase significantly over time. Earlier this year, we pointed out that the primary strategic aim of Royal Dutch Shell's (RDSB) bid for UK energy rival BG Group (BG.) was the latter's substantial presence in global liquefied natural gas (LNG) markets. This area of the global energy market certainly offers the strongest long-term fundamentals, although both British Gas and SSE have come under the cosh recently for failing to transition rapidly enough from power generated through coal-fired power stations. The two providers account for around 40 per cent of domestic power supplies, so they've taken the brunt of criticism due to a relatively modest drop in the UK's carbon emissions from generation - 8 per cent over the past 10 years.